The needful recession

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As December comes to a close, there is no longer any doubt or argument that the destruction of household wealth, the inevitable consequence of an unwinding of the housing bubble, and an orgy of debt of unprecedented and unparalleled proportions has triggered an intense and dangerous recession in consumer spending. This is the first consumer spending recession since the early 1990s and based on evidence that is piling up rapidly, this recession is destined to rival, if not exceed, in severity the worst consumer recessions in the last 60 years.

While I continue to believe that the recession began nearly a year ago, the early months, while dominated by escalating troubles in the housing and mortgage finance markets, initially had limited impact on consumer spending. And the spring tax rebate bought a little time. However, this more violent stage was inevitable all along and is not the product of any particular event or errant public policy decision. It was inevitable because years of flawed economic policies had resulted in enormous imbalances in the economy. In other words, the entire foundation of the economy was rotten to the core. And like a house of cards, once widely held beliefs were brought into question and faith was lost, the system toppled with lightning speed.

The good news is that the entire economy is engaged in the recession now—there are no remaining sectors to be pulled in. But the bad

news is that an unwinding of the imbalances may not lead to a restoration of a stable foundation essential for a return to healthy economic growth.

Recessions are necessary and essential components of the business cycle. Joseph Schumpeter referred to them as periods of “creative destruction” during which the excesses of the previous expansion and the weakest components were purged. Like the survival of the fittest in the theory of evolution, recessions play a critical role in assuring a vibrant, high-growth economy over long periods of time. But, while recessions are underway, there is always risk that they can go beyond the needed cleansing process and become destructive agents of that which is good. That was the lesson of the 1930s when the U.S. economy became stuck at a level of significant underperformance relative to potential for over a decade.

It is with the risk in mind that a recession, once underway, might not be self-correcting that economists and policymakers have long agreed that monetary and fiscal policy intervention is essential. However, getting policy intervention right is a tricky matter. If it is too successful, some of the rot remains in the system and excesses that should have been purged remain to wreak further havoc in the next expansion. In this regard, I am reminded of the long-standing U.S. Forest Service’s policy of preventing forest fires and its enormously successful marketing campaign spokesperson—“Smokey the Bear.” The policy was to prevent forest fires, and for 50 years it was extremely successful. However, after enormous conflagrations in the western U.S. more than a decade ago—particularly the spectacular infernos in Yellowstone Park—the Forest Service reassessed policy. What it discovered was that preventing forest fires resulted in debris accumulating over time and increasing the available fuel, which steadily increased risk of major fires as time passed. The policy also interrupted nature’s natural renewal cycle. Policy was revised and Smokey the Bear’s role was adjusted accordingly. Today policy is aimed at managing forest fires to fit with natural forces, although care is taken to limit destruction of human life and property.

The Forest Service policy failure is apropos of decades of overzealous economic policy intervention. We have been too quick to stanch recessions. When coupled with policies aimed at promoting housing and consumption, we have let the debris build up steadily over several decades. Now the great conflagration is upon us and our traditional policy responses have at best only slowed, not stopped, the destruction. This time around policy needs help to purge the excesses, avoid an overshoot, and manage the inevitable pain and suffering.

For example, there is a “natural” level of home prices relative to income and there is an appropriate proportion of household income that should be spent on housing relative to other goods and services. Policy should not be aimed at overconsumption of housing or in supporting unaffordable prices. Housing prices are still 10 to 15 percent on average above affordable levels, and that imbalance needs to be eliminated. However, how that necessary adjustment occurs and what policies accompany the adjustment in prices will have enormous impact on households and the overall economy. We cannot eliminate the pain. But we must try to avoid an uncontrolled downward spiral that results in home prices much below the “natural” affordable level. The collateral damage to people and the economy, if that were to happen, is unthinkable.

The onset of the virulent portion of the recession and the consumer’s full engagement can be dated from the events of mid-September, including the placement of Fannie Mae and Freddie Mac into conservatorship, the bankruptcy of Lehman Brothers and the collapse of AIG. Investors sensed the sudden deterioration in the economy and stock prices crashed. Consumer confidence fell to record lows and spending plummeted. Businesses reacted by slashing capital investment and employment. Unfortunately, as always happens in the early stages of recession, as unemployment rose and income fell, consumer spending cuts were validated and reinforced, setting into motion a vicious circle, which continues to this date.

While the conservatorship of Fannie and Freddie briefly conveyed hope that some semblance of functioning might be restored to the mortgage finance market, this was quickly dashed and matters got even worse as the FDIC at the prodding of the Treasury moved to guarantee bank debt. This had the unintended consequence, even in light of the government’s role as conservator, of making the debt of the government-sponsored enterprises (GSEs) inferior. Risk spreads rose. In the deleveraging frenzy that gripped markets, investors shunned any type of security, including mortgage-backed securities (MBS) and GSE debt, that did not have an explicit government guarantee nor had a term to maturity beyond one year. Traditional housing finance securities simply had no takers in a world obsessed with liquidity and avoiding risk at all costs. The result was that mortgage rates remained at high levels. Mortgage rates must come down and come down a lot. If they don’t, the only way to achieve housing affordability will be through home prices declines.

September housing price data revealed reacceleration in housing price declines. It is quite probable that October and November data will be equally disappointing. Belatedly, the Federal Reserve, just prior to Thanksgiving, announced its intention to buy up to $500 billion in MBS and $100 billion in GSE debt. This was hailed by the markets, but still is woefully short of what is needed. The Fed’s action puts it in the place of investors who have disappeared. This has a positive benefit on mortgage rates to the extent that the gap between supply and demand diminishes. But it has not changed the risk profile of investing in these securities. What is needed is explicit guarantee of GSE debt, at least on a basis equal to that which is already in place for bank debt.

In the meantime, the rapid worsening of the economy and rising unemployment is accelerating the rise in mortgage delinquencies. No longer are delinquencies focused only on sub-prime borrowers who were aggressively underwritten and put into extremely risky “affordability products.” The new wave of delinquencies is coming increasingly from traditional-conforming, fixed-rate mortgages. And the tsunami is coming. Lag times between unemployment, default and foreclosure cover many months.

We can expect much more aggressive action at both the state and federal level to limit foreclosures. This will include substantial pressure on servicers, similar to the agreement reached in the Countrywide/Bank of America settlement with state attorneys general, to be much more proactive in modifying the terms of at-risk or defaulted home loans. But it could also include an increase in the implementation of state foreclosure moratoriums and a federal moratorium when the new Congress takes office next year. The Emergency Economic Stabilization Act of 2008 requires the new Office of Financial Stability to pursue foreclosure prevention strategies vigorously. However, because Treasury decided to substitute capital purchases for distressed asset purchases, little has happened in the two months since this law was passed.

Though I think it would be a difficult solution to craft without unleashing significant potentially negative and unintended long-term consequences, many favor a modification of the Bankruptcy Act to give power to judges to modify mortgages for troubled households. The problem with this solution is that it is less efficient than what servicers can do directly. But if servicers don’t act aggressively to address the need for modifications to avoid foreclosures, the likelihood of bankruptcy legislation empowering judges to do so will become very high during 2009.

Fannie and Freddie recently announced a streamlined modification program to alleviate some downward pressure on housing prices and help many delinquent borrowers avoid foreclosure. The program is scheduled for implementation on Dec. 15, 2008. This program will cover about 30 percent of loans delinquent 90 days or longer or in the process of foreclosure (this 30 percent share is likely to grow significantly in coming months as unemployment continues to rise). The remaining 70 percent of delinquencies are composed of FHA loans, portfolio loans and private label securities. By far the largest percentage is in private label securities, and because of legal complexities surrounding pooling and servicing contracts, it is difficult to craft a workable, streamlined modification process for loans that are in trusts collateralizing private label securities.

Regardless of whether modifications are done one at a time or in batches through a streamlined process, there remains the matter of whether the borrower will perform on the modified loan or redefault. If the borrower is destined to redefault, the servicer more than likely could reduce losses by foreclosing immediately rather than modifying the loan only to have to foreclose much later on. But that is a judgment call and could deny modifications to borrowers who would work like the dickens to make it work. It should be noted that servicers are required by investors to pursue the option most likely to result in the greatest net present value of cash flows. The uncertainty of redefault at the margin results in some borrowers not receiving modifications who might perform pursuant to the terms. Such decisions, of course, exacerbate the number of near-term foreclosure sales, increase supply in markets and, because demand is limited, contribute to accelerating price declines.

The chairman of the FDIC, Sheila Bair, has proposed an approach to streamlined modifications that would result in loss risk sharing between the investor and the government in the event that a modified loan redefaults. The FDIC estimates the cost of its program would amount to $22 billion, although the actual loss probably would be lower. To get lending going again and to reduce the number of foreclosures, risk sharing has to be on the table. In this respect the FDIC proposal merits serious consideration.

But, when all is said and done, let there be no doubt that a healthy housing market, longer run, requires affordable prices in a range consistent with rents and past household housing expense to income ratios, and this means no longer relying in any way on housing price appreciation to close the gap. Housing prices must fall further before these stable, long-term relationships will be reached. The role of policy must be to find a way to achieve these healthy, long-term equilibrium levels with the least amount of pain and to do so in a way that avoids an undershoot in housing prices. This will be very challenging, but I am optimistic that most of the pieces essential to such an outcome are being put into place.